Tuesday, August 9, 2011

By indicating that it is likely to keep the federal funds rate "at exceptionally low levels ... at least through mid-2013," the Fed has done more with a few words than it could have done with a QE3, while avoiding the need to monetize more of the Treasury's voluminous debt issues. This is big news.

By promising to keep short-term rates near zero for at least the next two years, the Fed has driven a stake through the heart of money demand. Why hold on to money if it is going to pay you almost nothing for the next two years? Why not borrow all you can (institutional investors can borrow money at close to the funds rate) and buy anything that promises to pay at least a positive yield? The 25 bps collapse in the 10-yr Treasury yield in the hour following the FOMC announcement was the market's way of understanding this. Two years of almost-zero borrowing costs means that you can "sell the curve" (bondspeak for betting on a flatter yield curve, or borrowing short and investing long) with impunity.

Initially, bond yields fell on the news that the Fed sees so much weakness in the economy that it is ready to all but guarantee very low rates for years to come. But on reflection, what the Fed has done is to jumpstart simmering inflation expectations, which will eventually steepen the long end of the curve. The Fed can control short-term rates at will, and rates out to 5 and 10 years by extension, but it can't control rates much beyond 10 years, and it certainly can't control 30-yr rates. Already today we have seen the 10-30 spread widen by almost 10 bps, reaching a new high for the year. The bond market's knee-jerk reaction to surprise Fed announcements is often wrong, and this is a case in point. Same with the equity market: the S&P 500 fell 3% in the first 30 minutes following the FOMC announcement, and has now bounced back by 5% and looks set to close the day with solid gains.

Although weakening money demand and stimulating borrowing and leveraging is not necessarily a good thing for the dollar (understandably it has fallen since the announcement), it is not necessarily a bad thing for equities. Corporate profits have been stellar, and earnings yields are pushing 8%, so borrowing money at almost-zero to buy equities is a license to print money.

Today's FOMC announcement was one of the most convincing ways to encourage people all over the world to spend their dollars and borrow more that I can imagine.

I'm sensitive to the reflationary implications of this move by the Fed. But I do recognize that strong money demand (cash hoarding and deleveraging) has been holding back some of the recovery that I expected to see as M2 velocity picked up. (i.e., M2 velocity has remained quite low). Also, by weakening money demand the FOMC announcement could be seen as offsetting some of the extra money demand (fear-induced) which came from the downgrade.

Furthermore, I note Scott Sumner's point about how this whole crisis has been aggravated by unusually weak growth in nominal GDP. To the extent that this announcement stimulates growth in M2 velocity, nominal GDP should pick up and that should go a long way to alleviating the problems of large debtors. (If nominal GDP comes in lower than a borrower expected, then he has a big cash flow problem.)

Seems like a lot of financial engineering and jiggery-pokery to me. Individuals and funds which need 'safe' & 'secure' yield have been left in the lurch. The re-risk is back on whether you like it or not. America is the new 'carry trade' operator. This type of 'bubble' prosperity never lasts or works! Heliocopter Ben flying blind and nothing more!

Scott, thank you for your thoughts. The question I have is what happens, say 9-12 months from now, if we see a spike in inflation? What tools would the Fed have to fight inflation now that they have pledged to keep rates near zero until mid-2013?

Phil: your question is right on the mark. I have to believe that the Fed's move today will add to the inflationary pressure out there. I don't know how much, though, and I don't know what will happen if and when inflation picks up in a big way.

All I can say is that while this is good news for risky assets right now, it poses the very real threat of a big tightening of policy somewhere down the road. There is no free lunch.

If inflation started kicking in prior to 2013, the Fed could always stop reinvesting payments from its treasury holdings, which would be a small, relative tightening.

Also - and I admit I might be reading too much into this - but their statement said, "exceptionally low levels for the federal funds rate." I don't know about anyone else, but I would still consider a target of 0.25 - 0.5 instead of 0 - 0.25 to be "exceptionally low."

Finally, and again I might be reading too much into this, but notice it says:

"The Committee currently anticipates that economic conditions -- including low rates of resource utilization and a subdued outlook for inflation over the medium run -- are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013."

In other words, they did not explicitly say, "We're going to keep the overnight rate at 0 - 0.25 until mid-2013 or later. Period."

What they *did* say was, "we currently expect conditions to warrant such a low rate until mid-2013." That does not mean their expectations can't change in the meantime.

I think they probably did that on purpose to give the markets a reasonable amount of certainty about their intentions for the next two years, but also didn't make it so definite-sounding to give them no room to change their mind in the prior to mid-2013.

Actually, I think that the Fed has punted the ball back to Congress. The FOMC statement admits that the economy is worse than its prior forecasts. It admits that the Japan excuse was exaggerated and that the headwinds to real GDP growth are more structural here than the result of temporary external factors. Moreover, it is an admission that in a period of massive deleveraging, monetary policy alone is insufficient to bring this economy back to a 3% target of annual real GDP growth.

The only thing that has helped the unemployment rate in the past 12 months has been the exodus of over 2 million people from the group that is actively seeking work. Without that exodus, unemployment would be 10.5%. The Fed Funds rate has been 0-25bps for 2 years. QE1 and 2 created inflation that made the real Fed Funds rate negative. The recent revisions to GDP prove that real growth had been overstated by as much as 100% in some quarters.

The Fed cannot do anything more. So, it will maintain a middle course and try to do no more harm with another QE.

So, Congress now has possession of the economic hot potato. Given the downgrade, it will see its most important duty as making enough budget cuts and revenue increases to compel S&P to restore the AAA rating. That will be insufficient to restart economic growth.

There is no free lunch ... government should NOT be forcing investors and markets to do anything it doesn't want to do 'normally'! This is beyond wreckless! If I was S&P I would be downgrading treasury's another notch to 'AA' AND with a negative outlook immediately!

It's all about propping up the reckless lenders and penalizing the savers and earners. Nothing more. How the heck can the FED guanrantee that rates will stay at record infintessimal lows for 2 more years? We all know gold is wrong and there is no inflation - except in Zurich where ONE Big Mac will cost you $US17.19 today at lunch. But if this hyper inflationary move does 'stimulate' inflation what the heck will the Fed do then? What room is left to move? What will it do when it finally loses reserve currency status? Looks like the inmates are truly in charge of the asylum!

The ultimate bubble irony being created is within the US government's treasury market itself. The are working feverishly to set their very own trap and end game. When the bond market (final) bubble bursts you can turn out the lights the party is over. That is one that will never be blown back up!